World's biggest gold bug eyes miners

Date: November 21 2012

Richard Hemming

David Baker, the co-founder of London-based Baker Steel Capital Managers, which manages $1.2 billion of investments in listed gold miners around the world, says that times are tough right now, but investors need to hold on for the ride if the gold price runs through its record high of $US1920 an ounce.

“Gold miners have never been this cheap, and greed and fear are the two factors that drive share prices. If gold breaks its previous high you'll see the stocks in the sector run hard.”

There is a lot more to it, but once the market stops factoring in increasing costs of production, and believing the gold price to be a bubble, it's off to the races, according to Baker, who does not present as a diehard optimist.

The gold price is hovering around $US1724 an ounce, which is just over 10 per cent below its high. If it does reach its high, this is all the return that is on offer for gold exchange traded fund (ETF) holders. In contrast, Baker, who runs the biggest gold fund in the world, estimates that his fund would run up more than 40 per cent if this happens.

Moreover, this could happen sooner, rather than later.

“We are entering the seasonally strong part of the year for gold demand in November, December and January,” he says.

Greed and fear are the gold keys

The greed factor comes in when companies find big deposits (and there are precious few of them around). The fear factor relates to the prospect of hyper-inflation. This is definitely on the cards, with the trillions being pumped into the system in the form of quantitative easing.

It is the smaller gold producers that attract Baker Steel, along with a select few explorers, although he says: “Investing in an explorer is probably for someone either in his 20s or for the mega rich. It's a tough game.”

Why are gold stocks so cheap?

A key factor is the drain of money out of gold stocks and into the fast growing gold ETF market. The movement in these funds is meant to replicate the gold price, so they act as a proxy for holding the yellow stuff, and have often delivered investors a better return than investing in the gold miners.

ETFs in Australia are a recent phenomenon, and the first gold ETF was introduced in 2003. The value of the gold ETFs in the domestic market alone earlier this year was estimated at $140 billion, well in excess of the total of all listed gold companies on the ASX. That differential has widened since.

Before the financial crisis, gold producers routinely traded at big premiums - on price earnings ratios of 20 to 30 times, versus the market average of 15 times. These days they trade on about 12 times, on average.

Outside of money being pumped into the ETFs, another factor has been the poor performance of the sector leaders, Newmont Mining and Barrick Gold, whose management have made questionable decisions.

Says Baker: “These companies are spending a lot on production, but at the same time are struggling to maintain production [levels].”

Don't go big in gold, go small

One of their problems is that they're too big, which means that it is almost impossible to convince the market that they can grow gold production to a substantial extent. Newcrest Mining's shares have hardly reacted even though the company, along with South African-based Harmony Gold Mining, is sitting on what is possibly the biggest discovery for 30 years – the 13.3 million ounce Wafi-Golpu mine in Papua New Guinea.

Baker Steel's exposure to the mine is through a stake in Harmony. “This won't be in full production until 2023, and it means a lot more to Harmony's growth profile than it does to Newcrest's."

In next week's Under the Radar Report we discuss with David Baker and Baker Steel's gold analyst David Coates which gold stocks have this greed, sorry, growth factor.